On this week's Marketplace Money, Chris and Tess talk about all kinds of investments: annuities, SIPC, Coverdale IRAs and auction-rate securities.
TEXT OF GETTING PERSONAL (FIRST SEGMENT)
Tess Vigeland: All right, it's time for Getting Personal when we answer all kinds of confusing personal finance questions from you and with me once again is our economics editor Chris Farrell. Hello again, Chris.
Chris Farrell: Hello again and so what do you got for me?
Vigeland: Well, we've got Ria and she is with us from Raleigh, North Carolina. Hi Ria.
Ria: Hi there. How are you?
Vigeland: We're doing great and you?
Ria: I'm good, thank you.
Vigeland: All right, what's your question for Chris today?
Ria: My question is I'm about 10 years out of early retirement at 62. Recently a financial advisor of mine talked to me about annuities for retirement purposes and as much as I tried to understand them, I really don't completely get it, but what he recommended was to take half of my IRA and potentially invest it in an annuity for some stable income and my question goes around that. Really, what is an annuity? Is it recommended with where we are in the market these days?
Vigeland: OK. Well, let's take your questions one at a time. First of all, what is an annuity?
Farrell: An annuity... and the type of annuity that Ria, you're being sold, I assume is what we call a variable annuity. To you and I, it appears like a mutual find. You fund it with after-tax dollars. Your money compounds tax-free until you withdraw the money. At that point you pay ordinary income taxes on it. What I'm not sure is what the financial advisor is suggesting, but it sounds like he's suggesting that you have your IRA or half of your IRA as part of this variable annuity, but I've got a couple warning bells going off and I'm going to go right to my bottom line here, which is if you don't really understand how a product works, you don't invest in it. One of the concerns that I have is you don't want to mix in the same vehicle an IRA and a variable annuity and the reason why you don't is that an IRA is a tax-sheltered investment. A variable annuity is a tax-sheltered investment. If you mix the two together, you're wasting one of the most valuable aspects of an IRA which is that it is a tax-sheltered investment.
Ria: OK, the problem with the IRAs is that the market has been so volatile recently that it is not protected as well as the annuities are. Is that correct?
Vigeland: Yeah, we certainly are finding that and we talked about this earlier in the show, Chris, where, you know, it has been a wild roller coaster on the stock market, but you know your mantra is always you got to stick in there and hold it and not fold it.
Ria: But my question is... well, my long-term might be when it's going down again.
Farrell: So my main reaction to that is you know to have a much more conservative portfolio. A variable annuity is a good product for rich people.
Ria: What is your definition of rich these days?
Vigeland: Excellent question.
Farrell: My definition of rich is somebody who owns their own home, has maxed out on their 401(k), their 403(b), has maxed out on their IRA or their Roth IRA and once you've gone through all those basics, they still have discretionary income to invest.
Ria: OK. That would not be me.
Vigeland: OK, that would not be a lot of people. All right, does that help you out, Ria?
Ria: Yeah, it does. Thank you very much. Bye bye.
Vigeland: All right, let's reach into the email bag and Michael writes in from Rancho Cucamonga, California, not far from where we're sitting, and he recently received an email from ETRADE -- this is on the online brokerage. Seems he has an account with them and they must love him because it sounds like they're giving him five times the protection should anything catastrophic happen to ETRADE, which there were many rumors a few months ago that something catastrophic was going to happen.
Farrell: Think there may be a relationship there?
Vigeland: I think so. So anyway, this note from ETRADE said that the FDIC -- the Federal Deposit Insurance Corporation -- offers insurance up to $100,000 for the cash in his account, but ETRADE is a member of SIPC...
Vigeland: ...and this protects people who hold stock up to $500,000. What is this SIPC?
Farrell: That's the Securities Investor Protection Corporation. OK, when you're a customer at a brokerage house, you have several layers of protection. First, your assets: they're segregated from the firm's assets, so if the firm gets in trouble, you still have your stocks and your bonds in a segregated account; that's your first line of defense. Then comes in SIPC and that protection is up to $500,000 per customer.
Vigeland: So this is totally on the level and it's a good thing for Michael?
Vigeland: All right, well this is still a little confusing, Chris. Is there anywhere folks can go to get some more details about this?
Farrell: Ah, the web. The web! So there's the sipc.org. At this point in time, I think it's a really good idea that people understand how SIPC works.
TEXT OF GETTING PERSONAL (SECOND SEGMENT)
Vigeland: We're back with Getting Personal and Brian from Ann Arbor, Michigan, e-mailed our first question, Chris. He has two Coverdale IRAs for his two children.
Farrell: Used to be called the Education IRA.
Vigeland: Exactly, and he contributes to these when he can, but he's heard that the program is set to expire in the year 2010.
Farrell: Well, here's what's going to happen Brian: In its wisdom, when Congress rewrote the rules with the Pension Protection Act of 2006, it made a number of changes in the 529 plan permanent. So, for example, when you withdraw your money from a 529 plan and you go to pay for qualified educational expenses, it's free of taxes. But with the Coverdale, they left it alone, so some very good features of the Coverdale will expire in 2010; he's absolutely right. Now the Coverdale doesn't disappear, but what will happen is right now he can put or anybody can put $2,000 into a Coverdale. That will shrink to $500. It will continue to exist, but it will become a less attractive program. So, what you can do: you can leave the money there, do a tax-free rollover of the money into a 529 Plan and start contributing to the 529 Plan.
Vigeland: All right, let's go to the phones again and Tom is calling from Livingston, Montana. Hi, Tom.
Tom: Hi guys.
Vigeland: What do you do there in Montana?
Tom: Oh, I'm retired. A lot of skiing and a lot of fishing and enjoying this beautiful place.
Vigeland: Ah, sounds wonderful. Who did you work for?
Tom: I worked for United Parcel Service for 30 years.
Vigeland: OK, all right and what's your question for Chris today?
Tom: I have a question. We have a situation in the United States right now. It's called an auction-rate preferred security.
Vigeland: Uh-oh, yep. We're very familiar with these.
Tom: OK, I really don't have a question as much as I would just like people to know about this.
Vigeland: All right, well let's go ahead. Chris, can you define an auction-rate security for us? This has been in the news a lot recently because of the credit crunch.
Farrell: Yes and it is a real black mark on Wall Street. What it is: it's a $330 billion market. These were marketed as, you know, they're almost as liquid as a money market mutual fund, but you get a higher interest rate.
Vigeland: But what we found is that they are not quite liquid as they were promised.
Farrell: There are no buyers. At this particular point in time the market has ground to a halt. All the firms are struggling to figure out what to do about this. Usually what they're doing right now because people might have thought "Well, I'm going to pay my tax bill with this money" is "We'll lend you some money; we'll lend you a little bit. Oh, by the way: and we'll charge you a cheap rate of interest: 3 percent."
Vigeland: So Tom, I'm guessing that you owned some of these?
Tom: You're correct. My biggest question is why there was no notification?
Vigeland: So your broker never let you know?
Tom: My broker did not let me know, did not let my other friends that are involved know either.
Vigeland: Chris, is something that brokers should have been telling their clients?
Farrell: Oh, absolutely should have been telling their clients. It's caught a lot of people. At this point in time, Tom, I think it has grabbed everybody's attention because the problem hasn't gone away.
Vigeland: So is there anyway that he's going to be able to get his money out?
Farrell: Yes, I do believe that he will get his money out. To a large extent, I see that the credit crunch is starting to abate. It's not over with, but it's starting to abate. There are a lot of solutions that are being tried. A lot of firms are really embarrassed about this, but one of the troubling aspects of it is there are a number of money market mutual funds that own subprime securities and there was a real risk that the dollar that you put into that money market mutual fund would no longer be worth a dollar and a number of firms stepped in and they made sure that that didn't happen. It is unclear with this market; I think everybody will eventually get out at what we call at par -- they'll get their money back -- but the firms actually haven't been stepping up and it's disturbing.
Vigeland: So Tom, did you have a need for this money right away?
Tom: Oh, absolutely. I need to come up with a big chunk of it in less than a month's time from now and I'm basically strapped. I don't know what to do.
Farrell: Yeah, and what the firms are doing as I understand it is they're offering customers low-interest rate loans under the circumstances.
Vigeland: Is that something that you would think about doing, Tom?
Tom: Well, I don't really want to, but I don't think I have a choice at this time.
Vigeland: So Chris, let me ask you: is there a larger lesson here for investors in general? I mean, nobody saw this coming and auction-rate securities were considered and were marketed as this great financial vehicle and this has happened before certainly; auction-rate securities are not the first time. How do you know where your money is safe?
Farrell: The only lesson that I take from it and it's one that I know from a lot of our listeners; sometimes it's annoying. If you're getting a higher interest rate relative to a very safe security such as a Treasury Bill, you are taking higher risks. We don't know where that risk lies. Keep it conservative in terms of the amount of money that you are exposed. Probably nothing ever happens, but every once in a while something like a credit crunch comes through and the risks all the sudden become apparent.
Vigeland: All right, so Tom, unfortunately it doesn't sound like we have a whole lot of advice for you except to hang on and maybe go ahead and see if you can get one of those loans against it.
Tom: Right, right. I just wanted to get it out in the open and, like I say, because it hasn't been up here at all.
Tom: And so I appreciate you guys following up and letting me at least get out there and let people know what's happening.
Vigeland: Well, we appreciate the call. Thanks so much.
Tom: Well thanks you guys. Bye bye.
Vigeland: Take care. Chris. Thanks as always for the great advice.
Farrell: Thanks a lot, Tess.